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Morningstar | Suncorp’s 1H19 Highlights Inherent Earnings Volatility for General Insurers. FVE AUD 14.50 Unchanged. See Updated Analyst Note from 13 Feb 2019

No-moat-rated Suncorp Group’s sharp fall in first-half fiscal 2019 earnings was forewarned with the Sydney storm update on Jan. 3, 2019 but we were disappointed with the outlook for additional regulatory costs in second-half fiscal 2019, and higher natural hazard allowance and extra reinsurance costs in fiscal 2020. The Sydney hailstorm in December 2018 was the main culprit for the 13% decline in first-half fiscal 2019 cash profit to AUD 413 million compared with a year ago. Lower investment earnings and a doubling of regulatory spend were partially offset by increased reserve releases.

Despite interim cash NPAT and dividend being broadly in line with market expectations, share price weakness on the day is to do with the softer outlook for the diversified financial services group. The benefits of the diversified business structure stood out, with the particularly weak Australian general insurance result, NPAT down 43% from the previous corresponding period, or pcp, to AUD 133 million, partially offset by a solid banking performance, NPAT broadly stable at AUD 183 million, and a strong New Zealand NPAT, up 82% to AUD 111 million.

Our full-year earnings forecasts are modestly lower as the additional regulatory spend is partially offset by better than expected business improvement program, or BIP, benefits. We reduce our fiscal 2020 earnings forecast by AUD 122 million to AUD 1.2 billion to reflect headwinds of regulatory spend, increased natural peril allowance and higher reinsurance costs, partially offset by a better than expected likely outcome from the BIP. Longer-term forecasts are broadly unchanged. Looking ahead we expect a strong recovery in second-half 2019 earnings and higher natural peril allowances and reinsurance in fiscal 2020 should reduce volatility in earnings going forward. Despite headwinds, management’s medium-term targets are unchanged, with 10% return on equity, 12% underlying insurance trading margin and 60-80% dividend payout standing out.

Recent earnings performance has been patchy at best. However, the second-half fiscal 2018 result was impressive, and we appreciate the severe natural peril experience in first-half fiscal 2019 was outside the control of management. We liked modest group top-line revenue growth of 3.2%, with Australian home and motor insurance premium growth of 3.0%, lending growth of 2.4% in the bank and a strong 9.2% increase in New Zealand premium growth. Increases to premium pricing benefited insurance operations, partially offset by continued pressure on net interest margins in the bank.

Balance sheet settings are strong with the bank common equity Tier 1 capital ratio of 9.16%, including AUD 434 million in surplus regulatory capital. The downside of surplus capital and lower profits is a disappointing ROE of just 6% annualised for first half, based on cash earnings, being well below our 9% allocated cost of equity. The statutory NPAT of AUD 250 million fell 45% on pcp due mainly to a AUD 145 million writedown of goodwill due to the sale of the Australian Life business.

A fully franked interim dividend of AUD 26 cents per share declined on pcp but was a high 81% payout, above the interim dividend target of about 70%. Management confirmed the planned capital return of approximately AUD 600 million resulting from the yet to complete sale of the Australian life business to TAL Dai-ichi Life Australia. Completion is due by Feb. 28, 2019 but could be delayed subject to final regulatory approval. Management confirmed the AUD 600 million planned capital return will include a small special dividend to take advantage of surplus franking credits.

The business improvement project continues to gain momentum with AUD 95 million of benefits realised in the half, about AUD 30 million higher than target. The fiscal 2019 target net benefit from the program has been upgraded to AUD 225 million from AUD 195 million and is clearly on track. This is positive and necessary to offset the pressure on top line revenue growth, with fiscal 2020 target of AUD 329 million in net benefits targeted.

The unspectacular banking result highlighted the issues facing banks in Australia. Residential loan growth is decelerating, net interest margins are under pressure, partially offset by historical low losses. We expect these trends to continue for the foreseeable future. Despite good cost control, low revenue growth is putting upward pressure on cost/income ratios with the first half outcome up to 56.1% from 54.9% a year ago. Annualised loan losses of just two basis points are ridiculously low and are the lowest of major bank and regional bank peers by a long way.

Despite the solid underlying performance, in our view, the group is struggling to deal with external factors including natural peril costs, volatile investment performance, and unexpected regulatory expenses. Management’s response to these external factors is reassuring, but expensive. In addition to upping natural peril allowances and reinsurance cover, management have increased expected regulatory spend by AUD 50 million or 55% to AUD 140 million in fiscal 2019. Elevated regulatory spend will likely repeat in fiscal 2020.

The fiscal 2020 natural peril allowance has been increased by AUD 100 million to AUD 820 million, with an additional AUD 200 million natural perils reinsurance cover to sit on top of the AUD 820 million allowance. The additional reinsurance cover will cost between AUD 40 to 50 million. The Board and senior management have a lot to do during the next few years dealing with government and regulatory responses to the Royal Commission recommendations.